The US stock
markets have enjoyed an awesome run since late August, with the
flagship S&P 500 stock index (SPX) up 23.7%. Traders have earned
huge profits in sectors that leverage general-stock-market gains,
including commodities stocks. But as usual after any long and
uninterrupted rally, complacency reigns supreme today. Such
sentiment is a prime breeding ground for spawning corrections.

Nearly all
short-term price movements are driven by the collective emotions of
traders. When they feel good, they buy stocks. And rising prices
eventually lead to greed. When they feel bad, they sell stocks.
And falling prices ultimately spark fear. These two emotions are
perpetually warring, swinging back and forth like a great pendulum.
Greed dominates when prices are up, then fear flares when they are
down.

Complacency is a
close relative to greed. It is “a feeling of quiet pleasure or
security, often while unaware of some potential danger”. Like
greed, complacency grows when prices are high. The conditions that
generate it are long, uninterrupted rallies leading to big gains.
After the stock markets rally gradually for months without
retreating, the majority of traders start assuming the risk of a
selloff has vanished.

But this is always
a foolish assumption, as all markets flow and ebb. Bull
markets advance forward two steps before retreating one step in
their periodic selloffs. Far from being bad, these retreats are
extremely beneficial for traders. They rebalance sentiment,
bleeding off excessive greed and complacency. This extends the life
of the bull market, as it will burn out prematurely if greed sucks
in too many traders too quickly. And they drag prices back down,
creating the best buying opportunities seen in an ongoing bull.

The more years you
spend trading stocks as a student of the markets, the easier it
becomes to recognize the excessive complacency that leads to
stock-market retreats. It manifests universally in the things the
financial media reports, the way analysts and traders view the
markets, and how smug everyone becomes about the current rally
continuing indefinitely. As an example, this week on CNBC I heard a
professional money manager forecast “a 24% gain in the S&P 500
during the next 100 trading days”!

While the
subjective read on the collective emotions dominating the markets is
incredibly valuable, it takes many years to develop the experience
necessary for this skill. Thankfully there are hard objective
indicators that betray extreme complacency. When they get to
certain levels, the odds of an imminent retreat balloon
dramatically. All traders can watch these indicators as warning
signs preceding retreats.

I will explore
several of my favorites in this essay, the VXO implied-volatility
index, the SPX bullish-percent index, and the put/call ratio. My
charts this week superimpose the last couple years of S&P 500 action
(its current
cyclical bull) over these key sentiment indicators. As I
suspect you’ll agree after digesting this analysis, given these
indicators’ positions today probabilities heavily favor an SPX
retreat.

I use the word
“retreat” to encompass both pullbacks and corrections, which have
specific definitions in the stock markets. Pullbacks are retreats
in the major stock indexes running less than 10%, while
corrections are larger retreats weighing in at more than
10%. Provocatively given the extreme states of these sentiment
indicators today, it is increasingly likely a full-blown SPX
correction looms.

Let’s start with
the premier sentiment gauge, the VXO. It was the original
old-school VIX before that index was heavily modified in September
2003. Technically the VXO measures implied volatility in
at-the-money options, expiring 30 calendar days out, for the elite
S&P 100 stock index. This index represents the top 20% of the S&P
500 companies, the biggest and most-liquid stocks trading in the
US. During any material stock-market selloff, these are the
companies sold first, fastest, and most. They can readily absorb
huge volumes, letting traders exit quickly with minimal adverse
price impact.

Despite the new
VIX’s popularity with the financial media, the original-formula one
(now VXO) remains a much purer measure of sentiment. Today’s VIX
was diluted by adding the lower 80% of SPX stocks, which are much
less liquid and hence less responsive in major selloffs. It also
includes a broader range of short-term options, including
out-of-the-money ones that are also less responsive to market moves.

In the VXO, high
levels reflect heavy volatility and extreme fear. We saw epic
VXO extremes during 2008’s once-in-a-century stock panic.
Volatility and fear was off the charts. I used the VXO to call the
major SPX bottom early
in March 2009
leading into today’s bull. Conversely low VXO levels reflect greed
and/or complacency. And as this chart shows, the VXO has recently
ground down to some of the lowest levels seen in this entire stock
bull since the panic.

A month ago on
December 22nd, the VXO slumped to 14.37 on close. And then again
last Friday, it fell to 14.36. As the red VXO line shows, these are
very low levels relative to the past couple years. The only
other times the VXO has even come close to today’s levels were back
in April 2010 (14.26) and January 2010 (16.49). And look what
happened to the blue SPX line immediately after these reads.

The US stock
markets as measured by the flagship S&P 500 saw major interim highs
right at those previous VXO lows! After last January’s low
VXO reading indicating extreme complacency, the SPX promptly fell
8.1% over the next 14 trading days. While still in pullback
territory (less than 10%), this was the biggest retreat seen in this
entire cyclical bull to that point. Traders caught unaware got
slaughtered.

And then again
last April the SPX peaked right when the VXO hit the same
levels we’ve seen in recent weeks. Complacency was so out of hand
then that the SPX needed a full-blown correction to rebalance
sentiment! The stock markets ultimately plunged 16.0% in 49 trading
days, their first correction-magnitude decline of today’s cyclical
bull. Once again smug traders who didn’t expect such a selloff were
crushed.

These periodic
selloffs are such a big deal because their impact is leveraged in
hot sectors like commodities stocks. Losses in the large
commodities stocks during major SPX selloffs often amplify the
broader stock markets’ declines by 2 to 1 or more. So a 15% SPX
retreat, a garden-variety correction, can easily lead to losses
approaching a third in a matter of weeks for big commodities
stocks! And smaller more-speculative ones often fare even worse.
So gaming these periodic retreats is critical for traders.

If you can read
sentiment and anticipate such selloffs before they happen,
you can realize the gains on your existing trades near the preceding
interim highs. This builds up cash balances which are the perfect
way to weather a pullback or correction. After the retreats run
their courses, you can then buy back in to your old trades or launch
new trades with a lot more bang for your buck (your same capital can
buy many more shares).

So seeing the VXO
back down in the danger zone from which the biggest pullback and
only correction of this entire cyclical bull were born is a huge
warning sign. Traders have to understand that no matter how great
everyone feels about the markets today, the odds overwhelmingly
favor a serious selloff. Complacency is just too extreme, and since
the markets abhor extremes they are never sustainable.

The second
indicator to consider is the SPX’s Bullish Percent Index. It
reveals what percentage of the 500 stocks in this index currently
show buy signals in their point-and-figure charts.
Point-and-figure charting is an interesting relic from the dark days
before the Information Age. Easily done by hand, it didn’t require
computers and spreadsheets. It shows rising prices as columns of Xs
and falling prices as columns of Os.

These charts are
fascinating because they distill out the effects of time.
Each point-and-figure column can represent one day or many days,
within the same chart. Not showing time in the usual linear fashion
offers some unique insights into trends that normal price charts
can’t reveal. While this makes point-and-figure charting confusing
at first, it is a rigid discipline with well-defined rules. For BPI
purposes, any stock’s chart always shows either a
point-and-figure buy or sell. There is no ambiguity.

Like most
sentiment indicators, BPIs are contrarian. You want to buy
stocks when other traders are the most scared, because that is when
prices are lowest. And you want to sell when others are the most
greedy or complacent, because prices peak then. So a high SPX BPI
reveals extensive bullishness, hence greed and complacency, in the
stock markets. These are the times to sell and await a retreat.

Just this week the
SPX’s bullish-percent index soared to 87.4, meaning 87.4% of the
elite 500 stocks in this flagship index were showing
point-and-figure buy signals! Note that this is well into the
danger zone that marked the major interim highs before the biggest
pullback and only correction of this entire cyclical bull. Last
January before that big 8.1% pullback, the SPX BPI peaked at 83.2.
And in April before that 16.0% correction, it hit 87.2. Today once
again the SPX BPI is right at these dangerous levels.

When stocks have
been bought for so long that everyone thinks they are going to
continue higher indefinitely, all near-term buyers have already been
sucked in. So once some minor catalyst sparks any selling, there is
little capital left to buy stocks. The unimpeded selling soon feeds
on itself, scaring more and more traders into exiting their
positions. Super-high SPX BPI reads reveal these topping
conditions.

There appears to
be an exception to this rule back in September 2009. The SPX BPI
soared to 88.6 then, a more extreme reading than today, yet the
stock markets only retreated 4.3% in a mild pullback. So why
couldn’t we face a similar minor retreat today based on precedent?
It is important to remember that 2009 was a very atypical year
emerging out of the panic-driven extreme lows. Many sentiment
indicators bounced all over the place as the preceding anomaly
quickly worked its way out of the system.

The farther that
crazy panic recedes into the rearview mirror, the more the stock
markets are returning to normal behavior patterns. And in normal
times like now, extremely high SPX BPI reads almost always precede
major pullbacks or corrections. I certainly wouldn’t want to bet
against this well-established sentiment indicator, its historic
track record is excellent.

Finally take a
look at the put/call ratio, which measure the relative balance in
the options markets. When traders expect the stock markets to rise,
they buy calls. These give them the right to buy stocks at a
certain price for a certain period of time. When traders expect the
markets to fall, they buy puts. These let them lock in a selling
price today for months into the future. Like most sentiment
indicators, the PCR is contrarian in nature. When do traders buy
the most calls and puts? At exactly the wrong times!

Traders tend to
crowd into calls after a long uninterrupted rally. They extrapolate
the market gains out into infinity and assume the buying will
persist indefinitely. Since calls are the denominator of the PCR, a
low PCR reading (more calls than puts) signals one of these major
interim highs. Meanwhile traders prefer puts after a major
selloff, again expecting it to continue. So the PCR peaks during
major corrections, when traders are the most scared and expect the
stock markets to fall the farthest.

Since traders’
collective sentiment can vary wildly from day to day, the raw
put/call ratio is extremely volatile. To make it easier to analyze,
I use a 21-day moving average to smooth out some of these wild
spikes. This is effectively a 1-month average, since calendar
months average 21 trading days. Once again, this third sentiment
indicator reveals extreme complacency today. Traders fear no
selloff at all!

In recent weeks
the PCR 21dma has fallen as low as 0.766. Traders are buying far
more calls than puts, because they expect the stock markets to
continue to rise. This read is deep into the danger zone that
marked major interim highs before the biggest pullback and only
correction of this cyclical bull. Early in last January’s 8.1%
pullback, the PCR 21dma hit 0.769. And it slid to 0.786 a few days
into that 16.0% correction that started after April’s major interim
high.

Because of the
moving average applied to this indicator, it tends to lag slightly
(a week or so). But this isn’t a problem since the PCR downtrends
are already well-established before it enters its danger zone
warning of an imminent major stock-market retreat. If you watch
this indicator every day as we do, you know where it is heading
before it gets to the point where the odds of a selloff ramp towards
certainty.

After digesting
these three charts, see why I strongly suspect that an SPX
correction looms? Complacency is extremely high as measured by the
venerable VXO. The stock markets have essentially rallied nonstop
since late August with just a single minor 3.9% pullback in
November, so traders have forgotten about the ever-present selloff
risk. Their relentless buying has driven the vast majority of SPX
stocks into point-and-figure buy-signal patterns, a telltale
signature of major interim highs.

And options
traders feel the same way as stock traders, expecting the markets to
continue rallying in a straight line indefinitely. They have been
aggressively buying calls, betting on rising prices. Meanwhile
relatively few have bought puts, either to hedge existing stock
positions or actively speculate on a stock selloff. The markets
have been rallying for so long that few expect puts to pay out
anytime soon.

Yet indeed this
week the SPX’s correction may have already started. As
always though, sadly most traders will be caught unaware. They will
suffer serious losses in their stocks in sectors that amplify the
stock markets’ moves. Even worse they will get scared before this
correction ends, which will lead them to do most of their selling at
the absolute worst time near the bottom rather than now near the SPX
highs.

Recognizing the
increasing risks of major pullbacks and corrections before they
arrive is one of the great benefits of studying the markets. It
enables you to sell high which maximizes your realized
gains. It also gets you back into cash which is the ideal way to
ride out a serious selloff. Later you can use this cash to buy back
into positions near the bottom at bargain prices, starting the whole
trading cycle anew.

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The bottom line is
the key sentiment indicators are screaming that an SPX correction
looms. The stock markets have simply been running higher for too
long without interruption, so complacency has grown to extreme
proportions. This is never sustainable, the markets abhor any
emotional extreme and soon move the other way to rebalance
sentiment. As always, traders caught unaware will suffer serious
losses.

But there is no
need to be surprised, as very specific and measurable conditions
precede major pullbacks and corrections. Astute traders who watch
for these can sell into strength just before the correction,
maximizing their realized gains and protecting their capital in cash
through the subsequent selling. And then they are
perfectly-positioned to buy the resulting bargains near the bottom.
Corrections should be embraced, not feared, as they offer the best
buying opportunities in any ongoing bull market.